Among the various real estate investment strategies out there, Section 721 exchanges have risen in popularity thanks to their benefits to investors and ease of entry. This type of transaction allows you to join an umbrella partnership real estate investment trust (UPREIT). As you own operating partnership (OP) units, you become entitled to dividend distributions.
Before entering one, however, it’s essential to understand the 721 exchange benefits and risks to determine whether the investment is ideal for your financial goals. Below, Realized 1031 has shared a comprehensive guide to help you gain insights.
Thanks to the structure of 721 exchanges, investors can expect the following advantages.
The main reason people join an UPREIT is for the tax-deferral benefits. Selling an asset the traditional way makes you liable for capital gain taxes, which can make a huge dent in your proceeds. Section 721 of the Revenue Code allows you to contribute your property in an UPREIT in exchange for OP units. This transaction isn’t an official sale, which means the IRS won’t recognize gains or losses. Thanks to the indefinite tax-deferral benefits, you can preserve more of your wealth for longer.
An UPREIT Section 721 exchange is structured to remove as much involvement from investors as possible, so the investment offers truly passive income where you only need to sit and wait for your monthly dividend distributions. This setup is ideal for retirees or those who no longer want to take on an active management role in their investments.
Since investors have no direct control over the underlying assets of the UPREIT, it’s the REIT that manages operations and administration. These entities, which act as operating partners, have the resources, systems, and experience to ensure that each property under the UPREIT performs as projected.
UPREITs typically own various types of properties under different asset classes, sectors, or geographic locations. As you enter one, you immediately enjoy enhanced diversification due to the variety of properties, which makes your portfolio more resilient to market downturns.
OP units are easier to value once converted to REIT shares. This structure also makes UPREIT investments easier to divide among heirs. Compare this ease to directly owned properties, which can be harder to split among beneficiaries, and the estate planning benefits of 721 exchanges become more apparent.
You don’t need to convert OP units all at once if you need cash. The most common practice is to convert into REIT shares incrementally. This feature helps you avoid huge tax hits, allowing for better tax management.
The same structure that makes UPREIT investments beneficial also presents a few disadvantages that you must consider before committing your capital.
A 721 exchange doesn’t eliminate tax, only delays payments. As you convert OP units, you become immediately liable for the deferred capital gains taxes. For those who finish 1031 exchanges with a 721 contribution, all the previously deferred taxes will also be recognized, resulting in a major tax hit when poorly planned.
Some investors may still want some level of control or involvement in decision-making on their investments. If you’re one such individual, UPREITs may not be ideal for you, given the complete loss of control.
While not as extensive as those in Delaware Statutory Trusts (DSTs), UPREITs still have holding periods before you can begin converting OP units and selling REIT shares. The limit is usually just one year, and in some cases, there are also limits to how much you can convert per quarter.
For those who enter an UPREIT by contributing 1031 exchange assets, you’re also ending the cycle. REIT shares are not allowed as like-kind property, and so the only step forward is either holding the OP units until a step-up in basis applies or converting to REIT shares and getting your cash.
While both strategies provide tax-deferral benefits, these two have a few structural distinctions that make either one more ideal for certain types of investors.
If you’re someone who prioritizes passive income, hands-off involvement, and flexible tax payments, an UPREIT contribution may be the better choice.
Those who still want some level of control over their assets will find 1031 exchanges ideal. Plus, DSTs are eligible for the like-kind exchange, offering similar benefits as UPREITs while also allowing you to continue another 1031 exchange. At the end of the day, the decision lies with the investor's priorities.
Section 721 tax deferral, passive income, and streamlined estate planning are some of the advantages that make these investments an attractive option for many investors. There are certain drawbacks, however, like loss of control and eventual tax liability. When you’re aware of these possibilities, you can make more confident decisions as you consider UPREITs for your portfolio.
Sources:
https://www.investopedia.com/terms/s/stepupinbasis.asp
https://www.hellodata.ai/help-articles/what-is-an-upreit-in-real-estate
https://www.law.cornell.edu/uscode/text/26/721